I am the founder of a Chicago-based compensation consulting firm, The Delves Group (www.delvesgroup.com), that helps companies design compensation plans that embody governance principles and create shareholder value by aligning executives’ opportunities for incentive compensation with goals for corporate performance. I have more than 24 years of experience working for boards of directors, including those at large public companies. Before founding the firm in 2001, I had been a managing director with iQuantic, a partner with Sibson & Company, an executive compensation consultant with Towers Perrin, a manager with Arthur Andersen & Co. and a financial consultant with Harris Bank. I’m a Certified Public Accountant and hold an M.B.A. in finance from the University of Chicago and a B.A. in economics from DePauw University. For my doctorate from Fielding Graduate University, I’m writing my dissertation on compensation governance – specifically, on the use of compensation principles to guide directors in making decisions that are in the best interests of stakeholders. Among my published work are two books: "Accounting for Compensation Arrangements" (CCH, fifth edition, 2010) and "Stock Options and the New Rules of Corporate Accountability: Measuring, Managing and Rewarding Executive Performance" (McGraw-Hill, 2003).

2/16/2011 @ 1:03PM24,201 views

Is Incentive Compensation a True Motivator?

“Pay for performance” – the concept that executives’ compensation should be commensurate with the value they deliver to shareholders – has become a household phrase in recent years. The popular understanding of its meaning reflects the longstanding belief in corporate America that financial incentives are the most powerful motivator of executive performance.

Yet the findings of various studies by behavioral psychologists suggest otherwise. These findings have profound implications for companies large and small, for they raise questions about the motivational rationale underlying incentive compensation programs.

In the 1950s, researcher Harry Harlow observed the behavior of monkeys performing relatively complex tasks. Based on these observations, Harlow postulated that the very performance of these tasks was its own reward – that the monkeys were driven by “intrinsic motivation.” Unfortunately, Harlow did not pursue his remarkable discovery any further – perhaps because it was too threatening to 1950s beliefs about motivating people with “extrinsic” rewards, otherwise known as money. Starting then and continuing to the present, corporate America has institutionalized a system of incentive compensation supported not by behavioral studies, but by finance research. Extrinsic financial rewards to executives have increased at escalating rates, far surpassing the growth in a typical worker’s pay.

Nearly half a century after Harlow, psychological researchers comprehensively analyzed the results of 128 laboratory studies into the relationships between incentives, motivation and performance. Their findings concerning intrinsic motivation not only confirmed Harlow’s, but also showed that incentive-based (extrinsic) rewards can have the net effect of actually lowering performance.

Subsequent research over the past decade, most of it conducted in laboratory settings, also has found that incentives can limit or impair performance, particularly in situations requiring creativity and innovation. Summarizing the thrust of these findings in Drive: The Surprising Truth About What Motivates Us (Riverhead Books, 2009), author Daniel Pink outlines the potential unintended consequences of using monetary incentives: extinguishing intrinsic motivation, diminishing performance, crushing creativity, encouraging unethical behavior and fostering short-term thinking.

Behavioral researchers have found that external incentives can work against the inherent motivator of autonomy, our basic need to feel that we are in charge of our own destiny. Autonomy, relatedness (connection with others) and competence (a sense of mastery, accomplishment and achievement) are the core human needs and key intrinsic motivators at the heart of what is known as self-determination theory (SDT).

If the intrinsic motivators comprised by SDT are indeed critical to performance, one might ask, why haven’t they figured more prominently in corporate compensation programs? Why have companies instead put so much emphasis on extrinsic rewards? In formulating compensation programs, companies have relied not on psychological studies, but on research from the fields of accounting and finance. This research has been grounded in agency theory, which seeks to solve what is known as the agency problem: that company owners and agents who work for them (management), don’t have the same economic interests, so the solution is to use incentives to align management’s interests with those of shareholders. SDT implicitly challenges the rationale of basing incentive compensation plans largely or wholly on agency theory.

One of the detriments of extrinsic incentives, researchers have found, is that they can be addictive. Regarding this, Pink describes research findings published by Anton Suvorov in 2003: “A contingent reward makes an agent expect it [again] whenever a similar task is faced… Before long the existing reward may not suffice. It will quickly feel less like a bonus and more like the status quo, which then forces the principle [owner] to offer larger rewards to achieve the same effect.”

Of course, just because incentive compensation may be addictive doesn’t mean that it is necessarily ineffective at boosting performance in some circumstances; it might people to do things they wouldn’t otherwise want to do because they lack intrinsic motivation for the tasks in question. In fact, much of the research shows that extrinsic rewards are most effective in getting people to do repetitive, well defined tasks, or things they otherwise would not find personal meaning or value in doing.

Regardless, Suvorov’s findings have compensation governance implications: They may partially explain the escalation in executive compensation over the last 20 to 30 years. Further, his findings may in part account for the increasing disparity between senior executives’ compensation and that of the average worker. Higher-level managers and executives receive a greater proportion of their total compensation comprised by incentives; feeding an addiction to incentive rewards would widen this disparity.

However, the larger issue is how to provide effective intrinsic motivation and tap the true creative and innovative power of individuals and organizations. SDT research shows that people perform much better when they feel that their personal values and ideals are aligned with those of their organization, and where they derive meaning from pursuing the company’s mission. They also perform better when they feel a connection with other people and in environments where they develop a sense of mastery or competence.

This implies that companies that value creativity and innovation should have a meaningful and clearly articulated purpose and mission, and should hire and promote people who are in tune with that purpose. It suggests that camaraderie, teamwork and employee development are more critical to performance than lucrative monetary incentives.

However, people do work for money and most of us enjoy spending it, so a combination of monetary rewards and the softer motivational tools may be most effective. In the real world, the line between intrinsic and extrinsic motivation may not be a bright as it is for psychologists studying discrete phenomena in laboratories where all variables are known and quantified.

Nevertheless, the research findings raise provocative questions about the effectiveness of financial incentives as drivers of performance. By adroitly applying the findings, companies might be able to craft more nuanced, less formulaic compensation programs that are better suited to their needs and more effective at creating shareholder value.

Post Your Comment

Post Your Reply

Forbes writers have the ability to call out member comments they find particularly interesting. Called-out comments are highlighted across the Forbes network. You'll be notified if your comment is called out.